Discounted Payback Period

What Is the Discounted Payback Period?

A discounted payback period determines how long it will take for an investment's discounted cash flows to equal its initial cost. The rule states that investment can only be considered if its discounted payback covers its initial cost before the cutoff time frame.

I will briefly explain how the payback period functions to help you better understand the concept.

The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost). Certain businesses have a payback cutoff which is essential to consider when proceeding with investment projects.

This is why the payback period function is essential for companies. It enables firms to compare projects based on their payback cutoff to decide which is most worth it.

Understanding the Discounted Payback Period

When deciding on which project to undertake, a company or investor wants to know when their investment will pay off, i.e., when the project's cash flows cover the project's costs.

This is especially useful because companies and investors frequently have to choose between multiple projects or investments. Knowing when one project will pay off versus another makes the decision easier.

It is calculated by taking a project's future estimated cash flows and discounting them to the present value. Therefore, we are comparing the investment's initial capital outlay.

The time it takes for the present value of future cash flows to equal the initial cost of a project indicates when the project or investment will break even. After that, cash flows will be greater than the initial cost.

The faster a project or investment generates cash flows to cover the initial cost, the shorter the discounted payback period. Generally, projects should only be accepted if the payback period is shorter than the cutoff time frame. 

Advantages of Discounted Payback Period

The Discounted Payback Period offers several advantages that make it a useful tool in evaluating investment opportunities. 

1. Time Value of Money: DPB accounts for the time value of money by discounting future cash flows. This provides a more accurate reflection of an investment’s profitability compared to the regular payback period.
2. Risk Assessment: By focusing on how quickly an investment can be recovered in present value terms, DPB helps assess the risk. Shorter payback periods indicate lower risk.
3. Simple to Understand: Despite involving discounting, the DPB is still relatively simple to calculate and understand, making it accessible for non-financial managers.
4. Cash Flow Emphasis: It emphasizes cash flow over accounting profits, providing a clearer picture of liquidity and real economic benefits.
5. Comparative Tool: Useful for comparing different projects or investments, especially in capital rationing scenarios where a company has limited resources.

Disadvantages Of Discounted Payback Period

Despite its benefits, the Discounted Payback Period has notable disadvantages that limit its effectiveness as a standalone investment appraisal method.

1. Ignores Cash Flows After Payback: It may be missing out on important benefits that arise later in the investment's life by ignoring any cash flows that take place after the payback period.
2. Discount Rate Sensitivity: The DPB can be greatly impacted by the selection of the discount rate, which makes it rather arbitrary and sometimes inconsistent throughout projects.
3. Complexity in Estimation: It can be difficult to precisely project future cash flows, and any inaccuracies in these projections have the potential to skew the DPB computation.
4. Absent Examining Profitability: Although DPB emphasizes risk and liquidity, it does not give a comprehensive view of the overall efficiency or profitability of an investment. Not all of the most profitable projects have the shortest DPB.
5. Potential for Short-term Bias: There is a potential bias towards short-term projects. Investments that may be more profitable in the long run could be overlooked if they have a longer payback period.

Discounted Payback Period Calculation

To calculate, you must go through two steps. To begin, we must discount (that is, bring to present value) the cash flows that will occur throughout the project's years.

PV = FV / (1+i)^n

Where,

• FV = Cash flows or payments expected to happen.
• i = Discount rate/interest rate.
• n = Number of periods.

Second, we must subtract the discounted cash flows from the initial cost figure to calculate. So, once we calculate the discounted cash flows for each project period, we can subtract those discounted cash flows from the initial cost until we reach zero.

Example 1

Suppose company XYX invested $30,000 into a new operating machine that generates $8,000 yearly for six years. The company XYX imposes a payback cutoff of four years. Should you accept this project? 

Let's set up the cash flows as so:

Looking at the year's column, you can see that it took 3.75 years for the investment to break even. Since the payback cutoff is four years, company XYX should accept this project!

In real-life scenarios, depreciation is considered as it is unlikely an operating machine would remain optimal for an extended period.

Example 2

A project has annual cash inflows of $4,500, $5,100, $5,900, and $6,800, and a discount rate of 12 percent. What is the discounted payback period for these cash flows if the initial cost is $8,000? What if it was $14,000?

Let's set up the cash flows as so:

Divide the cost of $3,982.14 and the present value of $5,100 in year two due to the cash flow being more significant than the remaining initial cost. This method gives us how much less than a year it takes to complete. 

So, the discounted payback period would take 1.98 years to cover the initial cost of $8,000.

It would take 3.40 years to cover the initial cost of $14,000.

Payback Periods Vs. discounted Payback Periods

Now that we know the payback period is the length of time for an investment to break even, you may ask, isn't that the same thing as the discounted payback period? 

The answer is yes and no.

Here is a table to understand that:

Conclusion

By adding the time worth of money, the Discounted Payback Period, a complex capital planning technique, improves on traditional payback period analysis. As a result, it becomes a more precise gauge of an investment's risk and profitability.

The DPB provides a clearer image of an investment's underlying economic advantages. It computes the time required to recover an investment based on the present value of future cash flows.

The DPB's benefits include its emphasis on cash flow, which helps to grasp liquidity and actual economic gains, and its ability to account for the time value of money, which provides a more realistic risk assessment.

It is also helpful for comparing different initiatives, particularly in settings with constrained resources. However, it is not without its shortcomings.

It can result in an incomplete evaluation of an investment's long-term profitability since it excludes cash flows that occur after the payback period. Its sensitivity to the selected discount rate further raises the possibility of subjectivity in the analysis.

Additionally, there is a chance of bias towards short-term initiatives, and it can be difficult to precisely estimate future cash flows. Despite these drawbacks, it is nevertheless a useful tool when combined with other budgetary measures.

By balancing immediate liquidity concerns and a more accurate depiction of an investment's long-term value, it assists businesses and investors in making better decisions. As a result, the DPP is essential to thorough investment analysis and decision-making.

Free Resources

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